Dealing with Canada – Challenges and opportunities for global wealth and tax planners
Rahul Sharma and Jennifer A. N. Corak of Miller Thomson LLP present three common scenarios of non-Canadian or foreign trusts where Canada's Income Tax Act rules intersect with the international wealth planning of taxpayers
OVER the last decade, Canadian tax and private client practitioners have faced an ever-increasing amount of international and cross-border inquiries. Canada's rapidly changing demographics are partially responsible for this trend. The country's largest city, Toronto, and the region surrounding it, is the most ethnically diverse place in the world. Roughly half of the Toronto area's population is foreign born and belongs to a visible minority group. Similar demographic shifts are also at play in other major Canadian urban centres, including Montreal and Vancouver.
Unlike Canada's neighbour to the south, the country is not a 'melting pot'. Canada adopts a 'mosaic' approach to multiculturalism that, together with a resilient economy and financial sector, as well as an excellent standard of living, makes it an attractive place for educated and talented global professionals. The country's universities and colleges continue to be a destination of choice for foreign students.
All that said, new levels of wealth — many still tied in some way to their foreign jurisdictions of origin — are coming into Canada. This can be challenging from a tax and wealth planning perspective and involve meaningful tax implications and consequences; it may also give rise to opportunities that should simply not be ignored.
This article considers three common scenarios where Canada's tax rules often intersect with international wealth planning:
- The issues faced when the contributor of property to a non-Canadian trust becomes a Canadian tax resident;
- The opportunity presented when a non-Canadian tax resident funds a trust for the benefit of a Canadian resident taxpayer; and
- The challenges faced when a trust or estate derives the majority of its value from Canadian real estate.
Each of these scenarios will be discussed using hypothetical examples derived from the authors' own experiences.
Example 1: Non-Canadian Trusts And Canadian Contributors
Assume you are an advisor based outside of Canada. You are contacted by existing clients (Mom and Dad) who are looking to relocate to Canada. Many years ago, the clients funded a trust that is governed by Jersey (Channel Islands) law (the Jersey Trust) and that is administered from that jurisdiction by a trust company. As is often the case, the Jersey Trust owns all of the issued and outstanding shares of a British Virgin Islands (BVI) investment company (Investco). The directors of Investco are representatives of the same trust company that administers the Jersey Trust. Investco owns a portfolio of market securities that is managed by professional investment managers who are based outside of Canada. No one other than Mom and Dad has ever made a loan or contribution of property to the Jersey Trust. You know that Canada is a "high tax" jurisdiction. You wonder about the Canadian tax implications of the Jersey Trust.
We are often contacted by non-Canadian lawyers and tax advisors with a fact pattern similar to Mom and Dad's. These lawyers and tax advisors are sometimes surprised to hear about the application of the non-resident trust rules (the NRT Rules) in section 94 of the Income Tax Act (Canada) (the Act) to circumstances such as Mom and Dad's planned relocation to Canada.
The NRT Rules were enacted after 14 years of evolving pronouncements and were made to have retroactive effect, applying to taxation years after 2006. The NRT Rules replaced less detailed-and less stringent-rules that, by 2013, had been in place for decades. A detailed discussion of the NRT Rules is well beyond the scope of this article; in any event, only a brief summary of the rules is required to respond to Mom and Dad's circumstances.
The NRT Rules are generally engaged and may deem an otherwise non-resident trust to be resident in Canada where there is a "resident contributor" or a "resident beneficiary". A "resident contributor" is, in general, a person who, at any time, is resident in Canada and a contributor to the trust at that time. A person who has made a contribution to a non-resident trust prior to becoming a Canadian tax resident would become a "resident contributor" in relation to that trust upon the onset of Canadian tax residency. The non-resident trust in question would accordingly become a deemed resident of Canada for the purposes of the NRT Rules and will remain a deemed resident of Canada for so long as the trust continues to have either a "resident contributor" or a "resident beneficiary".
A "resident beneficiary" is a beneficiary who is resident in Canada if there is a "connected contributor" to the trust in question. A "connected contributor" is, generally, a person who has contributed property to the trust other than at a "non-resident time" of the person. "Non-resident time" is, in turn, generally defined in subsection 94(1) of the Act as the period that spans 60 months before and 60 months after the time that a contribution is made to a non-resident trust.
Complicated as it might already seem, the foregoing is, once again, just a small summary of the NRT Rules. The provisions in question are extensive and can be complicated in their interpretation and application, as well as their interaction with other provisions of the Act. There are, for example, extensive deeming rules that may cause certain indirect transfers of property to constitute "contributions" subject to the NRT Rules. The definition of the term "contribution" is itself detailed and includes loans.
Like most rules, there are exceptions to the NRT Rules. These exceptions are also extensive but are most often unavailable to settlements such as the Jersey Trust. It follows that if Mom and Dad become Canadian tax residents, the Jersey Trust is most likely to become a deemed resident of Canada for many purposes of the Act under the NRT Rules and accordingly, subject generally to Canadian tax payment and reporting obligations. Moreover, the Jersey Trust would be subject to annual taxation in Canada on an accrual basis in respect of the income earned and gains realised by Investco during a taxation year (Canada observes calendar year taxation).
Example 2: The "Granny Trust" - A Canadian Tax Planning Opportunity
Assume that Mom and Dad contact you and tell you that they continue to be very happy living where they are, but that their daughter (who is a discretionary beneficiary of the Jersey Trust) will be relocating to Canada for work. Mom and Dad are concerned about this relocation-they do not want their daughter to have to pay tax in any way in relation to the Jersey Trust or Investco, other than in relation to distributions made to her. Mom and Dad live in a tax-friendly jurisdiction outside of Canada and have never been Canadian tax residents. While Mom and Dad do plan to visit their daughter in Canada from time to time, they do not want to relocate to Canada or to become Canadian tax residents.
With a change in facts, the Canadian tax consequences in the first example become potential opportunities for the family and for the daughter. The Jersey Trust would, in this case, be what is commonly referred to as a "granny trust" by Canadian tax practitioners. Contrary to jurisdictions like the United States, Canada does not impose any tax measures on annual income that has been accumulated in a non-Canadian trust and added to the capital of that trust at the beginning of the subsequent year. Rather, distributions of capital from non-Canadian trusts to Canadian resident beneficiaries of those trusts are not subject to tax in Canada when received by Canadian resident beneficiaries. The distributions do need to be reported by the Canadian resident beneficiaries in Canada Revenue Agency (CRA) form T1142 in respect of the year of receipt (designating the distribution as being on account of "capital"), but no further actions or payments would be required by the Canadian resident beneficiaries.
Needless to say, if the facts and circumstances line up correctly, granny trusts are very tax friendly vehicles for Canadian resident beneficiaries. When a granny trust exists, it is important to:
- Adopt proper practices to ensure that distributions to Canadian tax residents are on account of capital only and that there is no income (which could include capital gains realised in the year) that forms part of the distributions; and
- Maintain all necessary precautions to not taint its status as a granny trust and, even inadvertently, bring it into the Canadian tax system. That could happen if:
- NRT Rules apply to some part of the trust (on account of a direct or indirect contribution by a Canadian resident); and/or
- The trust's "central place of management" is situated in Canada, such that the trust may be considered a factual (common law) resident of a Canadian province of territory.
Once again, these concepts are more complex than the points provided above. It is relevant to briefly discuss the "central place of management" test which, in the context of trust residency, arises from the 2012 decision of the Supreme Court of Canada in Fundy Settlement v. The Queen (2012 SCC 14) (Fundy Settlement).
In Fundy Settlement, the Supreme Court held that the common law "central place of management" test (otherwise applicable to determining the residency of corporations) should also be applied in determining whether otherwise a non-resident trust is, in fact, resident in Canada. It was clear from the facts in Fundy Settlement that Canadian resident beneficiaries exercised a considerable degree of control in the management and administration of the assets of trusts which were otherwise resident in Barbados. Since the Supreme Court's decision in Fundy Settlement, Canadian courts have consistently applied similar principles in determining whether a trust is resident in Canada and, more particularly, in a specific Canadian province (Discovery Trust v. Canada (National Revenue) (2015 NLTD(G) 86); Roy Boettger, Trustee of Nancy Smith Spousal Trust v. ARC (2015 QCCQ 7517); Boettger c. Agence du revenu du Québec, 2017 QCCA 1670). Like Fundy Settlement, these cases focused on the degree and level of control over trusts and trustee decisions exercised by beneficiaries in a particular (Canadian) jurisdiction.
Example 3: Ownership Of Canadian Real Estate By A Foreign Trust
For a final twist to the facts, assume that you are contacted by Mom and Dad regarding a proposed investment in Canadian real estate. Mom and Dad are very enthusiastic about investing in development lands outside of a major Canadian urban area. They are convinced that the real estate investment will generate significant returns (indeed, real estate investments in Toronto and Vancouver, in particular, have seen considerable increases in value in recent years). At inception, the Canadian real estate investment will constitute 35 per cent of Investco's total investments and value. Mom and Dad expect significant returns in the future and the value of the Canadian real estate investment could very well grow to constitute more than 50 per cent of Investco's value.
The Canadian real estate investment likely constitutes "taxable Canadian property" (TCP) for the purposes of the Act. In general, TCP is defined to include, inter alia, real or immovable property situated in Canada; property used or held in respect of an active business carried out in Canada (including inventory of the business); and/or the share of the capital stock of a private corporation which at any particular time or during the 60-month period before that time, derived more than 50 per cent of its fair market value from Canadian real or resource property or properties.
If the Jersey Trust owns TCP, the TCP would, under the Act, be subject to a deemed disposition and reacquisition on each 21st anniversary of the Jersey Trust's establishment (and not from the date of acquisition of the TCP). This is commonly referred to by Canadian tax practitioners as the "21-year rule". In Mom and Dad's case, the Jersey Trust will not directly own the Canadian real estate investment, which will instead be owned by Investco. The shares of Investco owned by the Jersey Trust will not, at the time the Canadian real estate investment is made, constitute TCP because more than 50 per cent of Investco's value will not at that point be derived from property that is TCP. The issue is what happens if the Canadian real estate appreciates significantly in value in comparison to other assets? What happens if the Canadian real estate increases in value while other assets depreciate, even for a day or two? There may be unexpected or unanticipated Canadian tax implications in such cases.
It is also important for Mom and Dad to note that the Jersey Trust may become subject to the application of section 116 of the Act if a capital interest in the Jersey Trust derives more than 50 per cent of its value at any time from TCP. In very general terms, section 116 of the Act requires amounts to be potentially withheld and remitted to the CRA, and for clearance certificates to be obtained from the CRA, in respect of dispositions of TCP. If the Jersey Trust derives more than 50 per cent of its value from TCP, a capital distribution from the Jersey Trust to a beneficiary who is not resident in Canada may, in certain circumstances, constitute a disposition of TCP and trigger a requirement to obtain a clearance certificate from the CRA under section 116 of the Act. Although relief may be available under a bilateral tax treaty between Canada and the jurisdiction of residence of the owner of TCP, Canada does not currently have a tax treaty with all jurisdictions-for example, Canada does not have a tax treaty with the BVI (or, for that matter, with Jersey).
The potential application of the 21-year rule alone dissuades many investors in Canadian real property from investing through trusts. Mom and Dad might indeed be best advised to not hold the Canadian real estate investment through the Jersey Trust structure. In any event, they need to be well advised of the potential Canadian tax implications of making the investment.
Conclusion - No Substitute For Proper Advice And Compliance
As with all international tax and estate planning matters, the devil is in the details. There is, in this respect, no substitute for proper Canadian tax and legal advice when dealing with a non-Canadian trust with ties to Canada. Compliance issues are important for Canadian resident contributors to, and beneficiaries of, non-Canadian trusts but also for the foreign trustees of such settlements.
Like many revenue authorities, international tax reporting and avoidance continues to be an area of focus for the CRA. The authors' recent experiences have included cases involving the CRA auditing the Canadian resident beneficiaries of granny trusts and raising questions in relation to the tax filings of deemed resident trusts. Trustees who have sought Canadian tax advice and maintained proper records (from a Canadian tax and legal standpoint) have been particularly helpful to Canadian resident beneficiaries when the latter were pressed for answers by revenue officers.
By considering three practical examples all relating to the same original fact pattern, this article has shown how, when dealing with non-Canadian trusts with a nexus to Canada, a change in facts can have a potentially significant impact on the Canadian tax result. This has varied from circumstances that might be best avoided to potentially attractive planning opportunities presented, in particular, by a granny trust arrangement. As Canada rapidly internationalises, these planning opportunities should not be missed; neither should the all-necessary tax reporting and compliance obligations.
Rahul Sharma is a partner and Jennifer A. N. Corak is an associate in the Toronto office of Miller Thomson LLP. This article was previously published in IFC Review (International Finance Centres Review).